It’s useful to think about the precise difference between the “New Keynesian” (Woodford) and “New Monetarist” (Williamson) effects of monetary policy. In New Keynesian models, monetary policy is important primarily because it affects the real interest rate, shaping patterns of consumption and investment across time. If interest rates are high, it’s expensive to buy a car or build a factory, and even ordinary consumption becomes less attractive compared to the return from saving. If interest rates are too high, consumers spend less than the economy can produce, and we see a recession. A good example of this type of model is in Eggertsson and Woodford’s classic piece on the liquidity trap.

In New Monetarist models, monetary policy is important for a completely different reason. Certain kinds of “decentralized” consumption require you to hold money balances; by manipulating the relative rate of return on money, the Fed makes this consumption more or less attractive. When money is expensive, buyers consume less in “decentralized” markets, and we see a downturn. A good example of this type of model is in Williamson’s forthcoming AER article, which builds upon the canonical piece by Lagos and Wright.

It’s silly to deny the existence of either effect: in a qualitative sense, they both hold. But it’s also important to know the magnitudes, and that’s where my skepticism comes in.

Consider the traditional instrument of monetary policy: the federal funds rate. Suppose that the Fed announces a surprise rate hike of 1%, to last exactly one year. What happens?

First of all, even though the Fed only controls the nominal rate, we can expect to see a real rate increase of at least 1% as well. Why? Since the rate increase will last only one year, the Fed’s long-term policy rule remains the same, and long-term inflation expectations stay anchored at roughly the same level. The only way that we can get a real rate increase of less than 1%, then, is if there’s a temporary uptick in inflation—and in virtually any model, that’s associated with an expansion, not a contraction. Certainly this won’t result from an increase in the policy rate. At best, inflation will stay roughly constant; at worst, it’ll fall.

A one year real rate increase of 1% means that all consumption or investment today becomes 1% more expensive, relative to consumption or investment a year from now (which is pinned down by the same fundamentals that existed before the shock). The effect won’t be even across the economy: durable goods will fall much more than, say, food. But to summarize the situation, we can say that all $15 trillion of GDP become 1% more expensive relative to next year. This is the New Keynesian effect.

The New Monetarist effect, on the other hand, is driven by the nominal interest rate. A 1% increase in the federal funds rate pushes down the annual yield of non interest-paying base money, relative to other forms of liquidity, by 1%. Right now, paper currency is the only type of base money that doesn’t pay interest, and there’s a total of $1 trillion in circulation. Taking the midpoint of various estimates, let’s say that roughly half of that is held in the United States. Furthermore, of that $500 billion, let’s be exceedingly generous and say that all of it is being used to facilitate legitimate economic activity. Then a 1% increase in the federal funds rate increases the implicit cost of holding this money by $5 billion. This is the New Monetarist effect.

You don’t need to be an economist to see that in our calculations, the New Keynesian effect is vastly larger than the New Monetarist effect: ($15 trillion)*1% = $150 billion versus ($500 billion)*1% = $5 billion. That’s a factor of 30!

Granted, these back-of-the-envelope calculations don’t explicitly tell us what the economic effect will be. That’s a much more complicated calculation, and it depends on the precise mechanics of the model. But they certainly are suggestive, and unless the New Monetarists have some trick up their sleeves, it’s awfully hard to see how the New Monetarist effect can be nearly as important as the New Keynesian effect at business-cycle frequencies.

In fact, many obvious modifications of the model only widen the spread between New Keynesian and New Monetarist effects. Some sectors of the economy are much more responsive to costs (including interest rates) than others. When the Fed raises rates, we expect a large decline in the demand for cars, but a much smaller change (if any) in the demand for food at home. That’s because cars are durable goods that provide value over time—their exact date of production isn’t so important, and it can easily be shifted around in response to the cost of capital. Consumers’ ability to “intertemporally substitute” basic sustenance, on the other hand, is virtually nil.

But where is New Monetarist effect least relevant? In precisely the cases where spending is most flexible: fixed investment, large durable goods purchases, and other transactions that are virtually never made with cash. Our comparison above, therefore, actually exaggerates the extent to which the New Monetarist effect makes a difference.

The gap also becomes wider if we alter our thought experiment. Let’s say that the 1% rate hike lasts for two years rather than one. Then the New Keynesian effect becomes almost twice as large: all else equal, the economy two years from now remains pinned down by fundamentals, and consumption and investment today is now 2% more expensive relative to then. The New Monetarist effect, on the other hand, remains the same: it depends on the current cost of holding money, not the full path of interest rates.

Of course, a few caveats are in order. My analysis above is concerned with the Fed’s impact on the business cycle: the short term, not the long term. As we stretch our time horizon, the Fed’s ability to impact the economy via the New Keynesian effect diminishes, while the New Monetarist effect remains roughly the same. If we’re talking about the federal funds rate, I still don’t think that the New Monetarist effect is very important, for essentially the same reasons that I’ve dismissed the Friedman rule. Nevertheless, the comparison in this post doesn’t apply.

More importantly, I’ve limited the analysis in this post to conventional monetary policy—changes in the federal funds rate. As we’ve seen over the past several years, this is not the only form of monetary policy. Moreover, a great deal of liquidity creation takes place outside the Fed: at banks, or the Treasury. Modelling this activity is potentially very important, and I think that the New Monetarist program is quite promising when viewed in the right light.

But when it’s applied to changes in the central bank’s interest rate—which is still the channel for monetary policy in the vast majority of countries, the vast majority of the time—New Monetarism simply doesn’t offer much. As even the most casual back-of-the-envelope calculation will convincingly demonstrate, the New Monetarist effect is tiny compared to the New Keynesian effect, and there’s no reason to think that it’s essential for understanding the implications of monetary policy.

Matt, thanks for a thoughtful post. This is the second time, I have seen this more senior economist chiding grad students that they need to learn more economics. This advice is true for you, I and the author of the original post, and yet his delivery strikes me as *a bit* counterproductive.

Personally, I learned more from your post than the one you linked to. As a junior research economist who studies the real world in real time, I do not have the luxury of reading up on theoretical models that were conceived when the world was still in the Great Moderation. I study consumer spending and I am trying to figure out what’s going on right now in the economy. Yes, I need to re-read theory now that I have some exposure to the real economy…but I think there are some senior folks who could benefit from that too. It seems like a mash up of models might be our best bet…as you suggest. When the economy is all happy, we can debate which of the theoretical models has the largest marginal boost to our professional understanding.

From my own research (using household survey data from before the recession) and a lot of other better published papers by other people, I am concerned that the effect of interest rate changes on consumer spending might be weak. Add to that the possibility that current conditions might be making be making interest rates even less important to households.

From my own research (using household survey data from before the recession) and a lot of other better published papers by other people, I am concerned that the effect of interest rate changes on consumer spending might be weak. Add to that the possibility that current conditions might be making be making interest rates even less important to households.

I don’t have nearly the knowledge of the literature that you do (and in fact, I’d love to discuss it sometime if you’re interested), but my sense is that this is a very old dilemma: across the board, micro studies suggest surprisingly small responses of spending, investment, inventories, etc. to interest rates, which conflict with both the assumptions in theoretical macro models and our (apparent) historical experience of large fluctuations in response to monetary policy. Resolving this dilemma was a central piece of Ben Bernanke’s research agenda: his 1995 JEP paper with Mark Gertler posited a “credit channel” of monetary policy transmission that bridged the gap between small micro-level responses to the user cost of capital and the seemingly large macro responses. Later work with Simon Gilchrist hammered out a more explicit model of the “financial accelerator”.

I agree with Bernanke and Gertler that the macro effects of interest rates are probably much larger than most micro evidence suggests. Partly this is due to simple econometric problems (most measures of the user cost of capital are noisy, leading to attenuated estimates of the effect), but partly it is due to feedbacks like the ones identified by BGG that are present at the macro level but not the micro one.

Do you (or anybody else?) know what has been the history of the typical rate of interest paid on checking accounts (since the end of Reg Q) and overnight savings accounts in the US? I understand that it’s zero now, but what about the last 20 years? The reason that I’m asking is that the Bank of Canada maintains these figures and there there seems to be an ongoing failure in the Canadian deposits market. Checking deposits in Canada pay literally zero (I think for regulatory reasons), but even overnight savings have been stuck at around 20 bps since the early nineties. They used to follow the policy rate (a few percent below it) back in the eighties, but since the deposit rate first hit zero (in the 91-92) recession they got stuck at zero and never came back up again even as the policy rate when back up around 8%. The same thing happened to uninsured deposits (over $100K) after the 2001 recession.

I’m asking since it obviously has consequences for the significance of liquidity preference/money demand. Is there a record of typical deposit rates in the US?

I decided to use the St Louis Fed data to look at MZM instead since it’s the short rate portion of M2 so we can directly compare the rate to Fed Funds. Presumably it’s reasonable to think of the MZM rate as being composed of savings at the Fed Funds rate plus money at zero interest. If you do that you can compute a history of the implied zero interest money supply component of MZM (which I did). The number peaks at around $3.5Tn in 2006. So if you add that to outstanding currency you might get four times the amount of money. Which still only puts you a factor of 10 times less than the the NK effect. So real effects still dominate nominal ones by quite a wide margin as Matt says.

Thanks for doing the legwork on this, emuhd and K—this is a very interesting (and important) question.

I do have a few reservations. First, I’m not sure that it’s optimal to model the MZM rate as being composed of savings at the Fed Funds rate plus money at zero interest. From a theoretical perspective, it seems more reasonable to say that the ex-base money component of MZM consists of accounts paying less than the Fed Funds rate by some average spread, which compensates for the costs of intermediation. This spread is much larger for some accounts (e.g. traditional retail deposits) than others (money market funds), but unless the spread is increasing in the nominal interest rate, there will be one-for-one pass-through of changes in the federal funds rate to the interest rates on these accounts. And it’s really difficult for me to think of an economic mechanism that would make this spread increase with nominal interest rates—though, admittedly, I am not an IO economist and I don’t know much about the structure of the banking industry. Even if there is some short-run inertia in short-term interest rates on many deposits—meaning that average rates do not change one-for-one with the fed funds rate immediately—it’s hard for me to imagine that the change would be much less than one-for-one in the long term.

Even if it was, however, this wouldn’t necessarily mean that the effective spread was increasing. Banks, for instance, generally offer a variety of ancillary services that go with their accounts. Depending on the situation, these services can be priced at cost, above cost, or below cost (often at zero). If we see the spread between MZM interest rates and the federal funds rate increasing, that might just be because banks are decreasing their markups on various ancillary services and recouping the money by charging lower interest rates. (Apparently, this was often a way that banks got around Regulation Q back in the day—when rates are capped, start offering terrific side benefits to lure depositors. A little like the airlines serving terrific food back in the days of air travel regulation…) This could mean either an increase or decrease in overall efficiency, but either way it implies a distortion much smaller than is suggested by a larger fed funds/MZM rate spread.

Regardless, your calculations are a tremendously useful bounding exercise. For the reasons I’ve mentioned above, I think they provide an upper bound to the extent to which a higher federal funds rate distorts allocation between money and other assets—and the fact that this upper bound is still well below the “New Keynesian effect” certainly reaffirms my belief that New Monetarist effects don’t matter very much quantitatively.

They used to follow the policy rate (a few percent below it) back in the eighties, but since the deposit rate first hit zero (in the 91-92) recession they got stuck at zero and never came back up again even as the policy rate when back up around 8%. The same thing happened to uninsured deposits (over $100K) after the 2001 recession.

Wow, this is very interesting. Near-zero rates on savings deposits even when the policy rate is near 8% are incredible. My instinct is to chalk this up to some localized failure of the banking industry rather than a general failure of savings rates to rise more than one-for-one (after all, I can’t see how that could possibly happen in a sufficiently competitive banking industry), but it would definitely be fascinating to understand exactly why this happened.

I agree that the calculation is a kind of upper bound which assumes the Canadian situation. I’m going to look a bit harder to see if the data exists to back out the actual quantity of interest free money in the US (surely somebody tracks this?). I found the Canadian data (source is the Bank of Canada) that I posted to Nick’s blog a few months ago. “Incredible” is an understatement.

Oooh Adam! Maybe we’re still thinking about it! (Or maybe you meant the New Monetarists?)

Take a very simple model with no bonds at all. Just money and haircuts. And the price of haircuts is sticky.

The individual cost to me of holding a little bit more or less money than is individually optimal will be second order of smalls. Vanishingly small (third order of smalls?) in the limit as the desired velocity of circulation approaches infinity.

But there’s a feedback mechanism at work. In the simplest case, where Ms is fixed, and P is fixed, a 10% increase in Md, will cause 3rd order of small costs to the individual who holds 10% more money than is individually optimal, but a 10% fall in GDP at the aggregate level.

Definitely. There is no mechanism in new monetarist models like this one. More than that, however, I think that the story you describe can actually be described as New Keynesian. (Fun fact: Ball and Mankiw once wrote that they could “just as easily be called new monetarists”, and that “we regret our contributions to this terminological confusion”. That’s middle of page 9 here. Too bad Williamson and Wright eventually swiped the name!)

Why? I think we need to think carefully about the mechanism by which decisions that only cause third order effects to the individual can possibly cause a 10% fall in GDP. In old monetarism, you can just read it off from MV=PY, but to me that’s leaving far too much implicit. What change in incentives makes consumers buy less?

The only workable answer, I believe, is that the increase in money demand causes nominal interest rates to spike, and that the resulting high real interest rates makes consumption and investment dramatically less attractive.

In particular, let’s talk about base money. While I agree that this isn’t the only possible setting for the story you describe (we can imagine a increase in demand for money construed more broadly), this is clearly a case of tremendous practical importance, since in normal times the Fed adjusts policy almost exclusively by changing the supply of base money. Any valid theory of monetary policy must be able to account for this case.

So let’s suppose that demand for base money suddenly increases. (And hey, I’d even be happy with M1.) The old monetarist story is hydraulic: everybody wants 10% more money, they can’t possibly achieve this in the aggregate without deflation (impossible due to sticky prices), and in their efforts to privately hoard money by refraining from purchases, they only manage to bring down GDP.

But refraining from purchases isn’t the only way to get more base money. If you have any liquid assets at all (and most people, at least ones with budgets of economically relevant magnitude, do), it is easy to liquidate them and get base money. It seems much more plausible to me that someone will say “hmm, I need more base money, why don’t I take some cash out of my account?” or “I want more money in my checking account, why don’t I transfer some more from my savings account?” than “hmm, I need more base money, so I’m going to refrain from making otherwise useful purchases in an attempt to conserve what I have”. At most the effect on economic activity should be marginal.

Now, in practice it isn’t, but that’s because of the price response: as everyone tries to grab more of the fixed supply of money, the nominal interest rate increases to clear the market, until the marginal investor is no longer interested in money after all. And this higher rate alters incentives for everybody in a substantial way: it makes all kinds of consumption and investment more expensive.

Of course, in equilibrium the marginal level of liquidity services from money equals the nominal interest rate, so in some cases both “consumers are hoarding money because the liquidity services it offers outweigh the benefits from consumption” and “consumers are not spending because the high interest rate makes spending today too expensive compared to spending tomorrow” are perfectly valid descriptions of what is happening.

But I think the latter explanation is a more practical account. Of the components of base money, currency is economically a sideshow: it adjusts slowly and passively, it’s not used for many important transactions, etc. At business cycle frequencies, all the action is in the interbank reserves market. Yet this is a market that virtually no individual knows anything about. Their only contact with it comes through the transmission of the short rate in the reserves market to a much broader set of interest rates in the economy. In this light, talking about interest rates as the transmission mechanism rather than money hoarding seems much more practical, even if in an idealized sense both are responsible. (And regardless, you can capture what’s going on via the path of interest rates; the only question is whether you want to highlight the other side of the coin.)

By the way, this is as good a time as any to remark that I think many of the arguments for why “interest rates aren’t necessarily the key mechanism by which monetary policy affects the economy” are fallacious. I’ve meant to blog about this, but I haven’t really gotten around to it.

I’m told many models imply that interest rates are the key mechanism by which monetary policy affects the economy. But I’ve never been convinced. Start with a flexible wage/price model. In that case a one time increase in the money supply will tend to lead to a one time increase in all nominal prices and aggregates, leaving interest rates unchanged. Ten percent more money leads to 10% more NGDP. A currency reform is a good example. Obviously interest rates play no role in that process.

Not so fast! It’s true that if all prices are perfectly flexible, you won’t see interest rates playing a role, but that’s because the immediate transition in a flexible-price case (and the infinity that results if that transition doesn’t take place) hides all the mechanisms at work. If you take the vastly more realistic example of a flexible price limit—prices are adjusted every millisecond, but not instantaneously—then interest rates are key to the story. (Nick, I think I remember you talking about this limit before, so I guess we’re both fond of it!)

What’s ruling out the equilibrium where prices are kept at the same level forever, and real GDP stays the same? (So nominal GDP also stays constant.) Sure, in other equilibria, adjustment speeds along because producers expect everyone else to change prices, which incentivizes them to change prices themselves. But if everyone expects prices to actually stay the same, this motive isn’t there. Something else has to be going on. And that “something else” is the interest rate (both real and nominal).

If the real and nominal interest rates stay constant, and all producer prices stay constant, the consumer optimization problem doesn’t change—in this world, there’s no way that we can rule out the weird, stable-prices-after-monetary-shock equilibrium. Thus the response of interest rates is critical.

In this case, the increase in money means that the nominal interest rate plummets. In our hypothetical stable-prices-forever equilibrium, this implies a decline in the real interest rate. This means high consumer spending, which in turn induces producers to adjust their prices upward, making the stable-price equilibrium untenable. So we can rule out a stable-price equilibrium—and, in fact, with adjustments every millisecond we can confidently say that the transition to higher prices will take place almost immediately—but the story necessarily involves interest rates. I don’t see any other way.

1. Suppose, just suppose, that an increased money demand shock happens at a time when everyone is planning to visit the supermarket/output market *before* they visit the bank/bond market. So there’s a reduction in sales at the supermarket, and people’s realised income will be lower than they had anticipated. We have “false trading” going on already, before anybody ever gets to the bond market. Now suppose further that people extrapolate that drop in realised income into the future, so they expect their future income to be lower. When they finally do get to the bond market, their supply of bonds will be lower than it would have been if they had visited the bond market before the supermarket. So interest rates might, conceivably, fall rather than rise, if there’s an increased demand for money.

Add in the fact that not everyone has access to the bond market (borrowing-constrained individuals).

2. My “Peanut Theory of recessions” post/point.

Take a standard NK model, delete the bond market, and then assume that just one of the n goods has perfectly flexible prices and is traded in a perfectly competitive market. Call that one good “peanuts”. By assumption, n is a large number, and the peanut market is only a very small fraction (1/n) of the total economy. So it has a negligible effect on the predictions of the NK model. Now suppose there’s an excess demand for money, and a recession. But people can always get more money by selling peanuts. So it would be very tempting for an economist observing that economy to say that recessions are caused by the real price of peanuts being too low. But, by assumption, causality is reversed.

The only thing special about bonds is the assumption that the price of bonds is perfectly flexible, so the bond market always clears. If the price of some other asset like land or antique furniture were perfectly flexible, it could play exactly the same role in the model. This (I think) is what Scott means when he talks about interest rates being an epiphenomenon.